Working Paper: CEPR ID: DP3377
Authors: Lucio Sarno; Mark P. Taylor; Ibrahim Chowdhury
Abstract: In this Paper we test empirically the validity of the law of one price using data for five major bilateral US dollar exchange rates and nine goods sectors during the recent floating exchange rate regime since the early 1970s. Using threshold autoregressive models, we find strong evidence of non-linear mean reversion in deviations from the law of one price with plausible convergence speeds. Consistent with theoretical arguments on international goods markets arbitrage under transactions costs and with an emerging strand of empirical literature, these results contribute towards forming a consensus view in favour of discrete regime switching in deviations from the law of one price and the presence of differing non-zero transactions costs across a broad range of goods and countries.
Keywords: Law of One Price; Mean Reversion; Purchasing Power Parity; Real Exchange Rate; Threshold Nonlinearity
JEL Codes: F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| deviations from the law of one price (F31) | nonlinear mean reversion (C22) |
| size of the deviation (C46) | speed of reversion (C69) |
| transaction costs (D23) | price adjustments (L11) |
| deviations (Y60) | adjustment towards the law of one price (F16) |
| transaction costs vary across sectors and countries (F16) | price adjustments (L11) |